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What’s up with the dollar?

Rising US interest rates have failed to arrest a long-running decline in the dollar, now into its fourteenth month. Ahmed Behdenna looks at some of the reasons why.

Little more than a year ago the US dollar was riding high, fuelled in part by hopes the new president, Donald Trump, might succeed in achieving the seemingly inconsistent aims of cutting the country’s massive trade deficit while turbo-charging economic growth.

Trump’s positive effect on the dollar was short lived. After in December 2016 hitting its highest level in more than 13 years on a trade-weighted basis, the currency has been on a steady decline ever since.

Unusually, the fall has coincided with a sharp rise in US bond yields, which has pushed interest-rate differentials in the dollar’s favour against the euro and most other leading currencies.

As the chart above shows, since the end of June 2017 the spread between US and German ten-year government bond yields has widened by 28 basis points; yet in that time the dollar has fallen by ten per cent against the euro. That marks a clear reversal of the relationship that held for the previous eight years.

All talk, no action?

There are a number of factors behind the dollar’s weakness, none of which seem likely to disappear in a hurry.

Ever since former US Secretary of the Treasury Robert Rubin first talked about a ‘strong-dollar policy’ in the late 1990s, successive US administrations have been keen to talk up the currency. The policy was seen as a way to assure investors Washington would not intervene in exchange markets to debase the dollar.

With the Federal Reserve free to conduct monetary policy independently of the US executive, financial markets were well aware that in reality the strong dollar policy amounted to little more than fine words.

Nonetheless, with successive administrations mindful of the need to attract foreign investment to fund the country’s budget and current account deficits, those words were seen to matter. However, suddenly financial markets are questioning whether Washington’s long-standing commitment to a strong dollar is as firm as it has been for the past two decades.

Sentiment towards the currency deteriorated sharply in January when the market latched on to remarks from US Treasury Secretary Steven Mnuchin, who claimed a weak dollar was good for US trade. His remarks prompted the currency’s biggest one-day decline in ten months, pushing it to its lowest level since December 2014 on a trade-weighted basis.1

The slide came despite Commerce Secretary Wilbur Ross just hours later insisting the US administration was not abandoning the strong-dollar policy.2 The following day Mnuchin said his remarks had been taken out of context, stating that while he was not concerned by its current weakness, ultimately in the longer term he believes in the strength of the dollar.3

As for Trump, having in July 2017 told The Wall Street Journal “lots of bad things happen with a strong dollar”,4 in January of this year he said he “ultimately” wanted to see a strong dollar.5

Fixing the deficit

Although the market arguably overreacted to Mnuchin’s comments, the size of the move demonstrates the fragility of sentiment towards the dollar. Furthermore it is not hard to see why the dropping of the strong-dollar mantra and the mixed messages coming out of Washington are leading the market to suspect the policy has shifted to one favouring benign neglect, if not outright depreciation. A weaker dollar, after all, would probably be the easiest route to cutting the US’s record trade deficit.

Trump’s determination to achieve that goal can be evidenced by the raft of protectionist measures he has pushed through as he tries to make good on his ‘America First’ agenda and his vows on the campaign trail to repatriate the jobs of rust-belt supporters.

The US has already pulled out of the Trans-Pacific Partnership – a trade deal with 11 other countries bordering the Pacific Ocean – threatened to scrap the North American Free Trade Agreement with Canada and Mexico, and stalled negotiations on the Transatlantic Trade and Investment Partnership with the European Union.

Then in January the US slapped tariffs of as much as 30 per cent on imported solar equipment and 50 per cent on washing machines. While the tariffs aren’t directed specifically at China, it is the world’s biggest producer of solar panels and exported 21 million washing machines last year worth almost $3 billion.6

Whereas a strong US economy, coupled with protectionist measures designed to get the US trade deficit down, might in other instances have been expected to boost the dollar, this has failed to happen for a number of reasons.

Firstly, thanks to the renewed vigour in the economy, the country’s trade deficit has actually begun to rise, in December swelling to a nine-year high of $53.1 billion.7

Worse still, the Trump administration is embarking on a huge fiscal stimulus at the precise moment fears the US economy is overheating have begun to emerge. That raises obvious concern imports or inflation, and quite possibly both, could be set to spike. Either could spell trouble for the dollar.

The federal government deficit, having already increased 13 per cent to $666 billion in the fiscal year to September 2017, is widely expected to balloon after lawmakers recently pushed through a series of spending increases hot on the heels of deep tax cuts enacted earlier in the year.8 The deficit looks set to virtually double to $1.2 trillion by fiscal 2019.

That would already be more than five per cent of gross domestic product: if the tax cuts passed in December are made permanent, which looks likely, America’s budget deficit is forecast to exceed $2 trillion in less than a decade. US public debt, meanwhile, looks set to soar to its highest level since the Second World War. US Federal Debt owned by the public currently stands at 76 per cent of GDP. After factoring in the tax cuts enacted in January, to current Congressional Budget Office projections made last June, that ratio looks set to climb to around 100 per cent of GDP by 2027.

An eye for an eye

With the Fed simultaneously in the process of shrinking its balance sheet, the US is more reliant than ever on foreign savings to fund its $14.5 trillion debt mountain. China is the largest holder of US Treasuries, followed by Japan, with the two countries between them holding more than $2 trillion of US securities. All told, foreign investors hold $6.35 trillion in US government debt, more than twice as much as in 2008.9

Beijing, having expressed “strong dissatisfaction” with the US tariffs, is widely expected to respond with tit-for-tat measures. The risk is that these developments will curb a key source of demand for Treasuries, which is one plausible explanation for the recent sharp rise in US bond yields.

More worryingly for the dollar, Trump’s actions call into question its ability to act as the world’s de facto reserve currency over the long term. Already there is some evidence to suggest the world’s central banks have been diversifying their holdings of foreign exchange reserves away from the dollar.

According to data from the International Monetary Fund, the dollar’s share of global foreign exchange reserves fell from 66.5 per cent at the end of 2005 to 63.5 per cent at the end of September 2017 – a period when the dollar’s value on a trade-weighted basis was unchanged.10

The Reserve Bank of Australia reckons the share of total reserves allocated to non-traditional reserve currencies rose from two per cent in 2009 to almost seven per cent last year.11

Given the composition of foreign exchange holdings can be volatile, in large part due to fluctuations in exchange rates, it would be wrong to conclude from these figures that the dollar is losing its status as the world’s pre-eminent global reserve currency.

After all, the sharp rise in US bond yields seen in recent weeks will boost the comparative attraction of US assets to foreign central banks, desperate to get a return on their foreign exchange reserves.

However, given the risk that the US is embarking on a reckless expansion of fiscal policy at precisely the wrong time, it is not clear interest rate differentials are sufficiently in the dollar’s favour to encourage a swing in sentiment from the bulk of private sector investors.

That could change if the Fed were to tighten policy sufficiently aggressively to stamp out the threat of inflation. But given such a move does not look imminent, there is little reason to bet on an early recovery in the dollar’s fortunes just yet.

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RA18/0238/01012019

Ahmed Behdenna

Senior Portfolio Manager, AIMS Target Income fund

Main responsibilities

Ahmed manages the AIMS Target Income fund. Ahmed is a permanent member of the Strategic Investment Group (SIG), where all investment ideas that are proposed for inclusion in the AIMS portfolios are rigorously debated.

Experience and qualifications

Previously, Ahmed was a senior strategist within the Multi-asset team, leading the investment ideas generation process for Aviva Investors Multi Strategy (AIMS) fund range. Prior to joining Aviva Investors, Ahmed was a senior strategist within the Multi-asset Research team for Société Générale and beforehand an equity strategist with the same company, covering European markets.
Ahmed holds a Master’s degree in Applied Mathematics from the National Institute of Science of Rouen, France